Wednesday, September 23, 2009

Professional Sports As a Model For Bankers' Pay

Many commentators have, in the aftermath of the destruction wrought by reckless financial industry behavior, promulgated the view that restrictions should be placed on bankers' pay. The theory goes that there is a direct correlation between excessive risk taking and the expected monetary compensation derived from said risk taking. Most problematic is the reality that, contrary to the concept of risk - i.e it correlates with reward to the upside and loss to the downside - it appears that a downside never actually existed for some folks. Couple this perversion with the fact that Wall Streeter's annual compensation has reached a multiple of average US pay rivaled only by professional athletes, and it's easy to see why a lot of folks are outraged.

Watching ESPN last night, it occurred to me that professional sports has done a far superior job in structuring compensation for it's highest value added contributors - the actual athletes - than Wall Street has managed to do for it's upper echelons. A professional sports team is in fact a self-contained business, employing a wide range of individuals who are mostly paid standard, competitive salaries. The same holds true in the banking industry; a teller working at the deposit window is earning a modest wage, despite the handsome rewards that are doled out to those running the organization. The difference between the two industries however - besides the obvious variations in core business, is that professional sports leagues in America were able to foresee the adverse effects of ballooning salaries at the top of their member organizations, and implemented effective regulation of those salaries. Interestingly, each of the top three professional sports leagues in the US - NFL, NBA and MLB - have implemented differing strategies for tackling this problem. The three approaches can be likened to the respective league acting as the State, with varying degrees of interference. A brief description of each league's salary regulations follows:

National Football League
The most recent Collective Bargaining Agreement (CBA) between the League and the NFL Player's Association sets a salary cap for each team that is based upon the League's Projected Total Revenues (PTR). For 2008, the formula which determined the maximum amount each team could spend on player salaries was (PTR X 0.575 - League wide projected Benefits) / n , where n= the number of NFL teams for that year. Keep in mind that the CBA is a 361 page document, so in addition to knowing that attorneys had a field day with this one, we can infer that there are some exceptions to the above formula that can result in a higher or lower annual salary cap than the formula would imply. The point is though, each team has the exact same amount of money to spend on player's salaries each year.

National Basketball Association
The NBA's collective bargaining agreement is similar to the NFL's in that it's based upon a percentage of the League's annual revenue, and is allocated evenly across all teams. The NBA's system is more flexible however, evidenced by the fact that many teams "live" above the salary cap. There are specific portions of the CBA which allow for salary cap violations, most notably when a team wishes to re-sign a veteran player who has already spent at least 3 years with the team. There are also salary cap "taxes", meaning that for instance, if a team's salaries exceed a pre-specified amount, that team will be taxed by the league for it's excesses. By the way, those taxes are distributed evenly amongst those teams which did not disobey the salary cap.

Major League Baseball
MLB's Collective Bargaining agreement, the most free-market-like in professional sports, states that a player's salary is an amount to be determined between the player and the owner of the baseball team. There is no annual limit to the amount that a baseball team may spend on it's players salaries. There is however, a stipulation known as the Competitive Balance Tax; without getting into details, the Competitive Balance Tax is the theoretical equivalent of the progressive income tax system in the United States.

The three models above provide what I see as a relatively reasonable framework for the proper structuring of high level Wall Street pay. Salaries for each financial institution could be collectively based upon the trailing year's revenue. A substantial portion of that designated pay should be placed into an escrow account for around 5 years, and will be distributed accordingly assuming that certain performance measures have been met for the subsequent half-decade. In the event that the financial institution has significant losses for a given year, the escrow account will be used to shore up the bank's capital position. In the event of any sort of accounting scandal, the funds will immediately be distributed - in their entirety - to shareholders.

Could such a compensation model have prevented many of the problems we face today? My bet is yes.

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